May 27, 2014



Over time if you are losing money in the stock market it is your own fault. Even if you are just underperforming the market in general, it might be your own fault. For example, let's take the return of stock mutual fund XYZ. Many studies have shown that investors that own mutual fund XYZ underperform mutual fund XYZ.

How can this be? It happens because of investor behavior. Cognitive errors and emotions cause investors move in and out of mutual fund XYZ at the wrong times. A cognitive error is a pattern of thinking that impacts your behavior that is less than accurate. In other words sometimes your own brain gets in the way of making good decisions. Here are three of the most common cognitive mistakes I see.

Loss Aversion.People care more about losing 1$ than gaining 2$. There have been many studies that show in various ways that people are worried more about losing than gaining. How does this apply to investing? Here is just one example. Even though the stock market is up 150% in the last five years you are still worried about losing 10% so you cash out. The market then goes up 20% now what do you do. You put your money back in. Then it drops 30% and you get out again. Now you are so scared you can't do anything until 5 years later when all the news is positive everyone is talking about how well they are doing and boom you are back in the market again just in time for the crash. Now your case of mild loss aversion has turned into full blown loss aversion and you say "I am never going to invest in stocks again".

Gambling Behavior.Most investors don't throw away money like this but in general they are very poor at assessing the risks they are taking when they invest. I recently had a prospective client in my office who told me he just bought into a venture capital partnership for $50,000. Not that unusual but a very risky investment considering this person is over 70, still working and can't really afford to lose that money. He said "I will either make a fortune or get a great tax write-off." Clearly he knew the risk but did it anyway. It's a variation of the lottery ticket retirement plan.

Trust Bias.When people are dealing with their own money they are making very important decisions about their life, their future and the future of their family. Yet, I find many are overwhelmed by financial decisions especially investing decisions and get sucked into bad investments by trusting someone too much. I see it more in this part of the country than in some other places. Oh, so and so is a member of our church or is a friend of a friend and is such a nice person and you trust them. You are not looking for a mutual fund or an annuity you are looking for someone to trust. And it is not that people lie, they just sometimes omit or gloss over some of the important details that might affect your decision to purchase an investment. Financial advising is a relationship business. An advisor is not going to be in business long if they can't make people like and trust them. It's their job and they are good at it. If you are going to trust someone you should trust - but verify.

So how can you avoid cognitive mistakes? That is an easy question to answer but very hard to do. First you have to recognize that the problem exists, then educate yourself and finally look at things from a different perspective.

Take loss aversion for instance. If you know up front that at some point you are going to lose money and accept it as a condition of investing in stocks maybe you won't panic every time the market goes down.

Go back and look at the history of the stock market. In fact since 1980 the annual return of stocks as measured by the S&P 500 index (the 500 largest U.S. stocks) has been positive in 26 of 33 years. But, the average intra-year loss was 14%. That means that even though there was an average 14% loss at some point in the year the market has still been overwhelmingly positive.  Change your perspective. Realize that you will have losses but not permanent losses. Look at a downturn in the market as an opportunity not a disaster. If you can't do that don't invest in stocks.

Bill Oldfather is a fee-only financial planner and investment advisor. Oldfather Financial Services is an SEC Registered Investment Advisor based in Kearney NE.